What Really Happened In 1981

Forward by Alan Reynolds

Timothy Muris’s otherwise excellent piece “Ronald Reagan and the Rise of Large Deficits” (Independent Review 4 [winter 2000]: 365-76), necessarily misses some fascinating details known only to those of us who were actually there.

The transition team began operating out of David Stockman’s congressional offices shortly after Christmas 1980. That team of part-time volunteers consisted initially of myself, Larry Kudlow, and John Rutledge, periodically accompanied by Alan Greenspan and Allan Meltzer. By February 1981, as permanent appointments were filled, we were joined by Murray Weidenbaum, Craig Roberts, and others.

The economic plan, dated February 18, 1981, was titled “America’s New Beginning: A Program for Economic Recovery.” The economic assumptions of that plan had been dramatically revised at the last moment despite the noisy protests of the monetarists (Meltzer and Rutledge) and the supply-siders (Kudlow, Roberts, and I). Contrary to folklore, the controversy had been entirely about inflation, not at all about an allegedly “rosy” real-growth forecast; real growth averaged only 3.9 percent per annum in both the original and the revised scenarios.

The original forecast had inflation dropping to 4.2 percent in 1983 and to 2.6 percent by 1986. As it turned out, inflation fell even more quickly, to 4.1 percent in 1983 and 2.2 percent in 1986. In 1981, however, senior advisors Greenspan and Weidenbaum, like all mainstream Keynesians, did not believe inflation could come down that quickly unless real growth remained feeble. At their urging, the inflation estimates were revised upward to 7 percent for 1983 and to 4.9 percent for 1986. That change of forecast happened to be a great relief to David Stockman because higher inflation appeared to reduce future deficits greatly, thanks to flawed estimating procedures in use at that time (inflation was assumed to generate “bracket creep,” but not to increase spending, except for indexed programs).

The forecast for 1981 was that the economy would grow by only 1.1 percent, but the economy actually grew by 2.5 percent that year. We thought the recession would be sooner and shorter than it turned out to be, and that the Federal Reserve would not be squeezing as hard as it was by 1982. In both the original and the revised estimate, real growth was expected to average 4.5 percent after the recession ended. Too rosy? In fact, real growth averaged 4.3 percent over a much longer period, 1983 to 1989.

In Stockman’s 1981 plan, federal spending was forecasted to drop from 23 percent to 19 percent of gross domestic product (GDP) by 1986, but actual 1986 spending turned out to be 22.6 percent of GDP. That excessive optimism about spending restraint had nothing to do with the economists’ forecasts. After the Soviet Union disintegrated, defense spending was cut from 6 percent to 3 percent of GDP, making it easier to balance the budget. All the fuss about raising individual tax rates in both 1991 and 1993 was essentially irrelevant, except to the extent that real growth may have been slowed. Receipts from the individual income tax averaged only 7.9 percent in 1991-95 after two “tax increases,” compared with the 8.1 percent average of 1983-90.

Article: What Really Happened in 1981

Paul Craig Roberts

Having written a number of articles over the past twenty years showing that the “Reagan deficits” were the consequence of an unanticipated collapse in the rate of inflation (Roberts 1984, 1986, 1988, 1989a, 1989b, 1989c, 1989d, 1990, 1991, 1992; Roberts and others 1986), I was pleased to find Timothy J. Muris adding his voice to the discussion of this issue in “Ronald Reagan and the Rise of Large Deficits: What Really Happened in 1981” (Independent Review 4 [2000]: 365-76). Muris is correct that there was neither a rosy forecast nor a “Laffer curve” assumption that the tax cuts proposed at the outset of the Reagan administration would be self-financing. These facts are so obvious from official government documents and my own writings that it says a great deal about the carelessness or prejudice of the economics establishment that journalists such as Sidney Blumenthal and economists such as Benjamin Friedman (1988) could so successfully spread the views that Muris refutes. Considering the extraordinary misinformation that still prevails, however, it is worthwhile to strengthen Muris’s argument and to fill some gaps.

Congressman David Stockman was not the architect of Reaganomics. The architects were supply-side economists, most of whom were trained at the University of Chicago or by Chicago-trained professors. Supply-siders said that “stagflation” (simultaneous recession and inflation) and the “Phillips curve” (an inverse relation of the inflation rate and the unemployment rate) were products of a demand-management policy mix that used monetary policy to stimulate employment and high tax rates to restrain inflation. Supply-siders said that the easy money pumped up demand, while the high tax rates restrained real output. The result was inflation.

The supply-side cure was to use monetary policy in order to control inflation and to reduce marginal tax rates in order to stimulate the growth of real output. This altered policy mix, we claimed, would permit real output to grow while the rate of inflation fell.

The challenges confronting the new macroeconomic policy and any forecast based on it were the commitments of economists to the theory of the Phillips curve, the idea of “core inflation,” and the Keynesian interpretation of fiscal policy as a means of shifting only aggregate demand.

At the time the administration was preparing its budget forecast, widely used forecasting models had a core rate of inflation of 10 percent. That rate was seen as a floor even with restrictive monetary and fiscal policies (in the Keynesian sense). The administration’s marginal-tax-rate reductions were widely interpreted as a Keynesian fiscal stimulus. We heard endlessly that a forecast that combined tax cuts with falling inflation was not credible. It was especially not credible originating as it did at a time of double-digit inflation after years of rising inflation expectations. Nevertheless, we pushed through a forecast that combined both declining inflation and real-output growth equivalent to what had been achieved between 1976 and 1980. Most members of the economics profession considered that forecast to be an implausible combination, and they stuck with the Phillips curve. Federal Reserve Chairman Paul Volcker also considered the forecast implausible, as did his economic consultants.

In July 1981, David Stockman and Richard Darman might have been wandering around in a parking lot sharing deficit musings, as Muris reports, but the real action was taking place elsewhere. At a July 1981 meeting of the board of governors of the Federal Reserve System with its economic consultants (at which I was present as the administration’s representative), Alan Greenspan (among others) advised that a restrictive monetary policy would be overwhelmed by the tax cuts and therefore inflation would explode. Monetary policy, he said, was the junior partner, a “weak sister,” and could “do nothing other than a weak rear-guard action.”

Over the preceding months, the Treasury had explained to the Fed on numerous occasions our view that a change in policy mix would free the economy from worsening Phillips-curve trade-offs. We had emphasized that the Fed must gradually tighten but stay within the target ranges. Our biggest mistake was to overestimate the Fed’s capacity for independent judgment. Instead, the Fed was guided by conventional wisdom, panicked, and slammed on the brakes. The tax-rate reductions had been delayed, and the economy hit the skids. The unexpected rate of disinflation not only reduced the tax base but also built in higher levels of real spending than the administration had intended.

Political partisans and economists defending their intellectual commitment to demand-management theories have done much to obscure both the policy goals and the achievements of the Reagan administration. But the two decades that have passed since 1981 have given us the results that supply-side economists predicted: two record back-to-back economic expansions–if not one expansion briefly interrupted by war and policy uncertainties–while inflation fell and then remained low. The changed policy mix worked. It was not implausible, impossible, or “voodoo” economics after all.

References

Friedman, Benjamin. 1988. Day of Reckoning: The Consequences of American Economic Policy under Reagan and After. New York: Random House.

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